This article is intended to lay out some of the issues facing futures traders. We have seen the statistic that 100 percent of all first time futures trading accounts go to zero. We have no data to confirm that, but we also have no reason to think that it is not at least close to the truth. Someone once said that the worst thing that can happen to a new futures trader is to have a profitable first trade. It makes the person get over confident, which is a trait that will eventually lead to big losses.
The reason many are attracted to futures trading is that they can use a small amount of money (margin) to control large sums of money. This is what gives the potential for large gains or large losses. The successful trader will use stops, never meet a margin call (just exit the trade), and stay mechanical and emotionless. It is a business, there will be gains and losses. One must learn to use probability in his/her favor, and be nimble.
1. What is Futures Trading?
A futures contract is not ownership of a commodity, it is a promise to buy or sell a commodity at a certain price and at a certain time in the future. Very few traders are interested in taking delivery of the commodity, but rather are speculating on price action and close their trades before delivery time.
Traders are actually buying and selling contracts and not the actual commodity. An order to buy or sell might open a new contract or close out an existing contract. The open interest is the total of all open contracts. Higher open interest generally provides better liquidity and tighter bid/ask spreads.
Futures contracts can now trade almost 24 hours per day except weekends. This makes it a bit less risky than the days when you could only trade a few hours a day while the exchange was open and your broker was in his office where he had to call the orders in to the trading floor. Now you can have stops in place that give some protection while you sleep, as long as there is someone willing to take the other side of the trade.
2. Tax Implications of Futures Trading
Unlike stocks, with futures you don’t have to report each transaction to the IRS, just the gain or loss for the year, which appears on the brokerage statement submitted to the customer on Form 1099B. The trader will use Form 6781 Gains and Losses from Section 1256 Contracts and Straddles with their tax return. Check with your tax adviser to verify that you have reported correctly. The IRS has been calculating gains on futures contracts by using the 60/40 rule regardless of holding period. Sixty percent of profits are taxed as long term capital gains and forty percent as short term capital gains.
Paying close attention to tax consequences is an important component of futures trading. If you have profits over certain amounts, you generally must make quarterly estimated tax payments to the IRS or pay an interest penalty. An additional consideration is that gains and losses are compiled at the end of each day with ongoing trades. This is unlike in the stock market where gains or losses are only reported for taxes upon exiting the trade even if the stock is held for many years.
As an example, let’s assume the trader in November has bought an April gold contract with expiration the following year. At the end of December gold went up and his trade has a profit of $10,000, but he keeps the trade until the following March while gold went down, at which time he sells at a small loss. Unfortunately for him, his broker had to report his gain for the year to the IRS on form 1099B. So the IRS demands that he pay taxes on the $10,000 gain that showed at the end of the year, even though the whole trade when finally settled netted him a small loss at the end.
3. Opening a Futures Brokerage Account
Most brokers require a minimum amount of cash to open an account. Traders often find that in order to place the kind of futures trades they want to make, they need more than the minimum account size. The margin requirements to trade some commodities can be rather hefty. Margin requirements are constantly adjusted due to market volatility, and can change while you have a trade in place. Margin amounts are set in order to protect all market participant’s ability to collect on obligations. The exchanges set minimum margin requirements, but individual brokers vary. Brokers sometimes have different margin requirements for individual customers as well. Margin requirements for day trades can be significantly less than for overnight.
4. Options on Futures
In addition to futures trading, options on futures contracts are usually available in a futures brokerage account. The large investment banks (in Las Vegas they would be called “the house”) are in the business of selling options to you, so this is a clue about who is going to make money over time. Just buying call or put options is a losing proposition for most traders. Successful options traders use more sophisticated option selling and buying strategies to hedge losses and lock in profits. When considering options trading you must first be familiar with various strategies. There are plenty of resources online where one can learn about option spreads and strategies such as vertical spreads, butterflies, condors, straddles, and strangles.